What caused the Eurozone debt crisis?

In November, the Australian published an opinion from the Centre for Independent Studies blaming the Eurozone debt crisis on social democrats, who “glossed over [the] inherent contradictions [in social democracy] by running massive deficits.” The Canberra Times also ran an article from the Institute of Public Affairs asserting that the crisis could be blamed on the “welfare state,” which “numerous studies show … impede[s] private sector production and growth by distorting incentives to work and save.” In an article curiously entitled “Eurozone v Australia: why we beat them,” Bob Carr suggests that our means-tested welfare system means Australia is unlikely to suffer a similar fate.

The Opposition warns us that the Government’s “reckless” spending places Australia at risk of a similar crisis. Kelly O’Dwyer thinks Australia’s public debt “rank[s] worse than Spain, Greece and Portugal” — “If this government were a pack of cards, then Wayne Swan would be the joker of deficits. Unlike Peter Costello, who is the king of surpluses, he would be the joker of deficits.” Barnaby Joyce claims that Australia has had the “third-biggest cumulative increase in real public debt since 2007,” apparently referring to this chart from an article in Policy Analyses in International Economics:

Indeed, Australia has the third-longest bar in this chart — because it measures public debt in 2010 as a proportion of public debt in 2007. Hence the “biggest” increases are those in countries which had relatively low public debt prior to the financial crisis, and the “smallest” increase was in Japan, the world’s most indebted sovereign. The trillions of dollars worth of debt issued by Japan since the crisis (around 40% of its GDP) appear relatively insignificant because Japan carried so much debt in 2007.

Australia’s increase in debt is far more modest when measured in gross terms or as a percentage of GDP. Clearly we’re not in the same economic position as the Europeans. But why? Carr cited Sweden as one of several countries with a government sector so bloated it consumes more than 50% of GDP, but the Scandinavian countries are in good financial health compared to the Eurozone.

Sweden, Norway and Denmark all have governments which spend around 60% of GDP. But despite the government’s dominance of the economy, they have relatively modest stocks of public debt (at 35, 11 and 60% of GDP respectively) and AAA credit ratings. Importantly, all three countries have a sovereign currency and run a trade surplus. The IMF doesn’t track the trade balance for individual countries, but it does track the current account balance (a broader measure which includes foreign investment income and international aid). Because current account deficits imply budget deficits, net private dissaving, or both, it is not surprising that many countries with consistently large current account deficits also have large budget deficits. In the following charts, countries are ranked by the indicator’s average over the 12-year period:

Source: IMF World Economic Outlook database, September 2011.

Source: IMF World Economic Outlook database, September 2011.

The “PIIGS” are the large-deficit countries without sovereignty over monetary and fiscal policy: monetary policy is controlled by the ECB, and fiscal policy is supposed to be limited by the Stability and Growth Pact to budget deficits of less than 3% of GDP. In any event, fiscal policy in the Eurozone is limited by the goverment’s ability to convince investors (including the ECB) to purchase its bonds. These constraints do not apply to monetarily sovereign countries like Australia.

The primary objective of the ECB’s monetary policy is to maintain price stability. Such policy, combined with persistent current account deficits in some countries (or, more or less equivalently, persistent surpluses in some countries, since the current account balances must sum to zero over all countries) will inevitably result in a public debt crisis. That countries in a single currency area — an area with a single currency or system of currencies with fixed exchange rates — would suffer periodic balance of payments crises was “patently obvious” to Robert Mundell in 1961, when he published A Theory of Optimum Currency Areas. Then, virtually the whole world was a single currency area under the Bretton Woods system of fixed exchange rates.

To paraphrase Mundell: floating currencies provide a natural role in smoothing out discrepancies between currency areas. Say that Dystopia and Eutopia share a currency area — that is, they use the same currency or fix the exchange rate between their currencies. When demand shifts from the goods and services of Dystopia to Eutopia, there is unemployment in Dystopia and inflationary pressure in Eutopia. To the extent that inflation is limited by monetary policy, unemployment in Dystopia is exacerbated. Conversely, inflation is exacerbated by monetary policy directed towards achieving full employment. In this analogy, Dystopia is the set of Eurozone countries with persistent current account deficits, and Eutopia is Germany. And because Germany’s fiscal strength depends on the rest of the rest of the Eurozone’s weakness — Germany’s trade surpluses imply budget deficits for its Eurozone trade partners — the Eurozone can’t just follow Germany’s example.

Those countries which share a currency area must be prepared to forego the benefits of floating their currencies against each other. In federations like Australia and the USA, a shared national identity makes it politically easier to use transfer payments to prevent differences in productivity between states from causing unemployment. The Eurozone debt crisis is a case study in the political difficulty of effecting such transfers between nations.

3 comments to What caused the Eurozone debt crisis?

I would like to add that the Eurozone debt crisis would be called the “the Eurozone currency conundrum” if it weren’t for the global financial crisis. The Eurozone countries had to take on much more debt as their revenues dwindled and money had to be flushed into national economies to support banks, industry (jobs), and confidence. The dimensions of the crisis are the fault of the financial services sector, the lack of fiscal management options is the fault of Eurozone monetary policy architects.

[…] Before going any further, a disclaimer: the discussion applies only to governments, like those in the the US, the UK and Australia, which are monetarily sovereign. Things are different when the government’s ability to spend its own currency is limited by a gold standard, fixed exchange rate or currency union. I discussed this previously in What caused the Eurozone debt crisis? […]